Nerves rattled over short-term outlook

The base metals price rally stalled during the report period Nov. 19-23 as the focus turned once again to the poor short-term outlook for consumption.

Copper was the market’s best performer, briefly touching US$1,530 per tonne (a 3-month high) and gaining 1.9% on its average cash price. Aluminum trailed behind, climbing just 0.9%. Nickel was the worst performer, shedding 2.8%, followed by zinc, which lost 1.1%.

In light of better-than-expected U.S. economic data, financial markets are increasingly pricing in a firmer economic future, though the short-term outlook for metals prices still looks uncertain. The Michigan sentiment index showed its second monthly rise while, at the same time, new jobless claims fell to their lowest weekly level in two months, adding to the previous week’s stronger-than-expected data releases (in particular, retail sales). U.S. interest-rate markets have now priced in an end to Fed easing; the Dow is technically in bull market territory (more than 20% above its September low); and the U.S. dollar continues to trend higher — yet so far there is no sign of any pick-up in metals-intensive parts of the U.S. economy. Auto producers are uncertain about prospects for car sales after setting records in October and many still expect auto output to fall early in 2002. Adding to the gloom is a fall in U.S. housing starts.

Prospects in Europe are even worse, with Germany sliding into recession after the release of negative gross domestic product data for the third quarter. Base metal stocks on the London Metal Exchange (LME) have seen modest falls recently, but more production cuts are needed to prevent metals prices from drifting back down.

Early in the week, copper prices hit their highest levels since late August; then, in the second half, they trended back down before managing a modest rally in a thin market on Nov. 23 to finish at US$1,476 per tonne. The spike that took the LME 3-month price to a peak of US$1,530 per tonne was fuelled by covering from brokers against call options granted when copper prices were below US$1,400 per tonne. All of this reflects the technical nature of the copper price recovery, which had earlier been kick-started by fund short-covering.

One factor that may slow the descent is the emergence of further production cuts. However, the market has probably factored in a another 100,000-150,000 tonnes of cuts from a combination of Grupo Mexico and Chilean producers. Anything less than this, and prices are likely to descend quickly back to the US$1,400-per-tonne level. The recent announcement by Konkola Copper Mines of a further 10% cut to its already-downwardly-revised production target of 220,000 tonnes for this year did not come as a surprise, given the operational problems that have beset the company. The market failed to respond to the announcement, and we have not included it among the running total of recent price-related cutbacks.

Aluminum prices followed copper back down from their recent peaks and, if anything, look more vulnerable than the red metal. The LME 3-month price ended the week poorly, below the 10-day moving average at US$1,365 per tonne, finishing at US$1,353. The next technical level of support is at US$1,330-1,335 per tonne. Tightness continues to build in the forward spreads; January, for a week, is now trading in a US$2.5-to-3.5-per-tonne backwardation. It is too early to tell whether or not the backwardation will develop with the same intensity that we saw in previous years, but we doubt it. The motivation behind previous first-quarter squeezes was to attract off-warrant metal into LME warehouses in order to sift for high-premium material. However, we believe there is much less aluminium held off- warrant than prior to previous squeezes. Also, given the financial difficulties that a major trading house-holder of off-warrant metal is currently suffering, it is probably in much weaker hands.

LME 3-month zinc prices continued to derive little benefit from the recent spate of production cuts and ended the week only slightly above the psychologically important US$800-per-tonne level. We expect this to come under pressure again soon, and if it gives way, a move down to US$780 per tonne is likely.

Recent production cuts have removed around 300,000 tonnes of mine production from 2002 supply. However, the consensus is that further large cuts are required if metal production is to be reduced, the reason being that global stocks of concentrate are high enough to last for some time. The lack of response in spot zinc smelter treatment charges, which remain at around the high US$180s, suggests there has been little impact on the zinc concentrate market yet.

One good indicator of when concentrate tightness begins to bite is likely to be Chinese exports of zinc, since China is heavily dependent on spot purchases of zinc concentrate. Smelter production slowed quite dramatically in October, falling 0.2%, year over year, to 159,000 tonnes, compared with growth for the year so far of 10.3%. This slowdown, which occurred despite the fact that concentrate imports remained high, is probably a reflection of the sharp contraction in Chinese mine output in third quarter, when the government closed numerous mines that were deemed inefficient and polluting. China’s zinc exports also fell in October (by 25%, year over year, to 37,000 tonnes), and further falls are likely if Chinese smelters find difficulty in sourcing spot concentrates.

The deterioration in nickel prices over the week was not surprising; in fact, had the U.S. market not been virtually entirely closed for the latter half of the week, we would have expected further falls and a more severe test of price support at US$5,000 per tonne. In the circumstances (quiet trading and limited U.S. participation), nickel was still weak and prices managed a drift through a number of support areas — for example, US$5,400 and US$5,200 per tonne.

Gold has now fully reversed its gains (both in terms of stature and prices) following the September attacks, and so the immediate questions to ask are: How much lower can prices fall, and by how much more can support areas in the US$270s area contain prices?

The most immediate potential source of upside pressure is physical demand and purchases. Even entering an Indian buying season, however, there is little sign that gold consumption is set to recover from recent dips.

In local currency terms, consumers fail to benefit from lower prices. The U.S. dollar is building on recent strengths and threatens to move higher still, given the nature of recent data releases from the U.S., the Eurozone and Japan. Although we recognize that U.S. dollar movements do not explain the full picture, we continue to suspect that, without significant dollar weakness, the prospects of an improvement in gold prices, both in the immediate and the medium term, are vastly reduced.

U.S.-dollar robustness has significantly restored confidence in the financial system and greenback-denominated assets (thus denying bullion the role of safe haven), while the rapid actions taken by the Fed have overshadowed the European Central Bank in terms of market confidence. Consequently, the chances of an upturn in prices in the immediate term appear to be limited. Toward US$270 per oz., physical buying interest can be expected to pick up and place a drag on price falls, though we doubt that this will occur in sufficient volume to halt the fall completely. Data from the World Gold Council have already shown weakness in demand, and with consumer confidence still fragile, expectations of a recovery are remote.

— The opinions presented are solely the author’s and do not necessarily represent those of the Barclays group.